A group of industry players have floated two new rate futures products that aim to solve problems with existing Treasury futures products and reduce reliance on over-the-counter liquidity.
Acceptance and listing of the products would put them squarely in competition with a host of recently launched hybrid swap futures offered by major derivatives exchanges, as well as a handful still being planned.
The contracts, dubbed Treasury Interest Rate Risk Futures and Swap Interest Rate Risk Futures are being hawked by a former NYSE Liffe product head now running his own company, Next Level Derivatives.
The TIRRF product, which physically settles into quarterly Treasury auctions, aims to provide more precise exposure to US government bond yields in lieu of popular CME Treasury futures contracts that Next Level says are harried by a host of design flaws.
The cash-settled SIRRF would be more akin to a hybrid swap future, closing off a spread to the corresponding TIRRF, providing a lower margin cost alternative to OTC swaps and creating invoice spread opportunities in tandem with the TIRRF.
It is a unique offer in the growing market for products that bridge the OTC and exchange-traded gap for interest rate exposures, but the duo faces hefty competition.
“The value of the SIRRF and TIRRF contracts compared to others is primarily in the quoting mechanism – contracts are quoted in yields so traders have more direct and easily calculable exposure to the government bond market than existing basket future contracts,” said Chas Mancuso, head of the firm and former head of fixed income product development at Liffe and co-head of fixed income futures at Jefferies.
“There are also a number of regulatory drivers pushing investors away from OTC markets – the combination of these factors is creating a need for better standard contract alternatives.”
At the heart of product structure is a belief that there is a better way to structure Treasury futures. Existing CME Treasury futures contracts reference the cheapest deliverable bond in a basket of maturities, such as the seven- to 10-year bucket that defines the popular T-Note futures contract at the exchange.
This means the contract can, and currently does, reference the seven-year point of the curve, conceivably an awkward hedge for those looking to reduce the risk of sharp ten-year price moves.
Additionally those contracts are quoted based on price, meaning traders have to make assumptions to back out what yield the contracts are exactly tracking. The fact that the new design tracks yields at a fixed maturity directly is enticing to some market-watchers.
“The quoting convention of the SIRRF/TIRRF contracts means they are equally sensitive to changes in yields at a fixed maturity at all times, whereas the legacy contract design inhibits the ability of traders to directly hedge or speculate on yields at a given maturity,” said Darrell Duffie, professor of finance at the Stanford University Graduate School of Business.
“The market has been lacking a product like this that provides specific Treasury curve exposure and still gets standardised treatment. However the chance of success of any new derivatives contract is uncertain, so it remains to be seen whether this new contract design will gain enough traction.”
Regulatory benefits
Mancuso is joined by former CFTC commissioner Bart Chilton and former LCH.Clearnet executive Sol Steinberg in pushing for market acceptance of the design. Chilton is now a lobbyist at DLA Piper, while Steinberg runs a boutique consultancy called OTC Partners.
The group believes the contracts also are well-timed to provide a cost effective alternative to transacting in OTC markets that have become increasingly expensive as a result of regulations, on top of the design benefits.
OTC interest rate swaps do provide opportunity for traders to tailor contracts to specific points on the yield curve, like Next Level’s contracts, but now attract higher margin costs than an exchange-traded future as a result of the new Dodd-Frank regime for OTC derivatives.
Additionally traders often purchase OTC forwards referencing future Treasury auctions to hedge their exposures. Those forwards are financed by term financing transactions in repo markets.
Repo transactions have become increasingly expensive for investors as banks have stepped back from market-making in order to comply with Basel III regulations. For example, the overnight rate for repurchase agreements increased to 0.45% on September 30, its highest level in three months.
“The benefit of a contract that is not reliant on repo should be a big attraction to users,” said Chilton.
Competitors
The new contracts still need a home, and would go up against a slew of other swap market offerings looking to address several of the same regulatory issues.
The SIRRF contract would be the seventh hybrid swap future contract launched or currently in development by derivatives market participants each looking to capitalise on increased regulatory costs in OTC markets. The TIRRF contract would not be a direct competitor to those offerings, but as a future that provides direct yield exposure, could be used in much the same manner.
CME Group, Eris Exchange, the InterContinental Exchange, NYSE Liffe, Eurex and Eurex-backed GMEX have all launched interest rate contracts. Nasdaq and the London Stock Exchange are said to be developing contracts.
CME and Eris contracts have seen some take-up, but it has been slow moving. Market participants say that even with the increased regulatory costs driving full bore, any of the new futures contracts will receive push-back from the speculative community if they are too simplified.
“Simplest is not necessarily best – hedgers generally want a simple, clean product but speculators want some quirks because they create profit opportunities,” said Michael Cloherty, head of rates strategy at Royal Bank of Canada.
“Whenever there is talk about new contracts, generally the hedgers line up wanting simplification while the speculators want weird. The ideal contract has just enough oddities to engage the speculators, but not so many that it becomes problematic for hedgers.”
The group says they have met with several exchanges but no concrete plans have yet materialised.
